Could an investment bank go to junk status?
Some of my “rules” were phrased as questions. I wrote that one prior to 2002, possibly musing about downgrades in the credit ratings of investment banks. But today we know the answer: NO.
There are functions in the credit markets that only belong to strongly capitalized entities. Anything involving a large degree of credit risk requires an exceptionally strong balance sheet. Though my original question was about investment banks, think of mortgage and financial insurers. Where are they today?
Looking at my list of financial/mortgage insurers from three years ago, this is what I find:
- Ambac Financial Group (ABK) — Aaa/AAA to C/CC (default in all but name)
- ACA Holdings — A to default
- Assured Guaranty (NYSE:AGO)— Aa3/A+ to A3/A+
- MBIA Inc (NYSE:MBI)— Aa2/AA to Ba3/BB-
- MGIC (NYSE:MTG)— A1/A to Caa1/CCC
- PMI — A1/A to Caa2/CCC+
- Primus Guaranty (PRS) — Baa1/BBB+ to B2/CCC
- RAM Re — Aaa/AAA — Ba3/NR
- Radian (NYSE:RDN)— A2/A to Caa1/CCC
- Syncora (OTCPK:SYCRF)— Aaa/AAA to default
- Triad Guaranty (OTC:TGIC)— A- to default.
Let me make a modest suggestion: financial and mortgage insurance does not work in times of extreme financial stress. Aside from Assured Guaranty every insurer offering coverage from financial/mortgage risks got smashed. Aside from AGO, all are at junk credit levels.
What this says to me is that the method of regulating financial and mortgage insurers is wrong. Financial risks are more severe than other risks, and a greater amount of capital must be held for solvency. When financial risks go bad, many risks go bad.
But wait, you say, at the greater level of capital, no one will buy the insurance. That might be true in the short run, but in the long run pricing levels will adjust. Insurance for mortgages will be bought, if the credit is secure.
Back to investment banks. They must be fundamentally sound institutions, given the high degree of leverage employed. Once they have a junk rating, fewer will do business with them, much like the financial insurers.
As a result my answer is no, no credit-sensitive institution can be junk-rated. Even a low-investment-grade rating is a stretch. During the boom phase, any investment grade rating can work; in the bust phase only the best market practices maintain a credit rating, and few credit sensitive entities maintain an investment grade rating.
Disclosure: No positions